Tuesday, November 17, 1998
DJIA             8986.28    -24.97      (-0.28%)
S&P 500          1139.32     +3.46      (+0.30%)
Nasdaq           1878.52    +16.84      (+0.90%)
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30-Year Bond    99 10/32     -2/32  5.30% Yield


Several financial services firms picked up steam today as the Federal Reserve provided the sector with its third interest rate jolt in two months. Alan "G-Money" Greenspan and his buddies at the Federal Open Market Committee cut the key short-term federal funds rate by a quarter point today to 4 3/4% -- its lowest level in four years. The Fed also shaved a quarter of a point off the discount rate, leaving that figure at 4 1/2%. The central bankers attributed the rate cut to "unusual strains" remaining in financial markets from the recent economic shocks in emerging markets, which is Fed-speak for "We ain't outta the woods yet!" Merrill Lynch (NYSE: MER) moved up $3 1/8 to $66 5/8, Chase Manhattan (NYSE: CMB) gained $3 3/8 to $61 1/4, Hambrecht & Quist (NYSE: HQ) rose $2 1/16 to $23 1/2, Donaldson, Lufkin & Jenrette (NYSE: DLJ) added $2 11/16 to $38 1/8, and Wells Fargo (NYSE: WFC) climbed $1 3/4 to $40 5/8.

Electronic transaction processor for the healthcare industry Envoy Corp. (Nasdaq: ENVY) gained $7 1/2 to $39 15/16 after yesterday announcing the "Resolution of Accounting Issues Raised by the Securities and Exchange Commission." The issues in question have to do with acquisition accounting, and the actual combination technique in question has become de rigueur among "technology" operatives. Yes, that's right, the concerns surround In-Process Research & Development (R&D) charges. But since Envoy had net losses for the last two fiscal years, restating its numbers to reflect higher goodwill actually had the effect of reducing the company's reported losses. For more information, interested Fools should check out today's Fool Plate Special on Envoy's "accounting issues."

QUICK TAKES: Online retailer Amazon.com (Nasdaq: AMZN) moved up $22 1/4 to $148 1/2 after opening two new stores on its website, which will sell videos and digital video disks (DVDs) as well as a new line of holiday gift products. For more details, see this morning's Breakfast With the Fool... Citizens Corp. (NYSE: CZC) gained $2 5/8 to $33 1/16 after insurance and financial services company Allmerica Financial Corp. (NYSE: AFC) agreed to raise its offer for the 16.8% stake of the property and casualty insurer that it doesn't already own to $33.25 per share in cash from the $29 per share originally offered last month... Office supplies retailer Staples Inc. (Nasdaq: SPLS) pounded out a $1 3/8 gain to $35 3/4 after signing an advertising and promotion deal with Internet content integrator, aggregator, and disseminator Yahoo! (Nasdaq: YHOO). For its part, Yahoo! rose $3 1/2 to $176 3/4.

Human resources information services company Ceridian Corp. (NYSE: CEN) moved up $3 1/2 to $58 7/8 after agreeing to buy the LifeWorks global work/life services unit of privately held workplace consulting firm Work/Family Directions Inc. for undisclosed terms. Merrill Lynch also gave Ceridian a lift by raising its near-term rating to "buy" from "accumulate"... Internet advertising software firm and recent StockTalk guest NetGravity (Nasdaq: NETG) rose $2 1/8 to $18 1/16 after announcing 25 new customers in Asia and the opening of an office in Hong Kong... Enterprise software developer Peregrine Systems (Nasdaq: PRGN) took flight, gaining $3 to $36 1/2 courtesy of a BT Alex. Brown upgrade to "strong buy" from "buy."

The American depositary shares of British drug delivery firm SkyePharma (Nasdaq: SKYEY) were launched skyward for a $1 11/16 gain to $13 9/16 after an FDA advisory committee recommended accelerated approval of DepoTech's (Nasdaq: DEPO) DepoCyt drug for treating the cancer-related condition of lymphomatous meningitis. DepoTech agreed to be acquired by SkyePharma earlier this month... LeukoSite Inc. (Nasdaq: LKST) added $1 7/8 to $12 1/8 after Hambrecht & Quist upgraded the developer of cancer and autoimmune disease drugs to "strong buy" from "buy"... Kava manufacturer and former Daily Double Pure World (Nasdaq: PURW) was lifted $1 5/32 to $9 3/8 after announcing a 10% common stock dividend payable Jan. 15, 1999.

Computing products direct marketer Insight Enterprises (Nasdaq: NSIT) gained $1 1/2 to $35 after the company was chosen to replace Marquette Medical Systems (Nasdaq: MARQ) on Standard & Poor's SmallCap 600 Index... Harrisburg, Pennsylvania-based bank holding company Keystone Financial (Nasdaq: KSTN) picked up $1 3/8 to $30 3/4 after being chosen to replace Firstar Corp. (NYSE: FSR) on the S&P MidCap 400 Index. Firstar is merging with Star Bank (NYSE: STR). Slot machine maker Anchor Gaming (Nasdaq: SLOT), which will take Keystone's place on the S&P SmallCap 600 Index, rolled $2 5/8 higher to $49 5/8... French life insurance and financial services giant Axa S.A. (NYSE: AXA) advanced $3 to $59 5/16 following reports in British newspapers suggesting the company may be eyeing insurer Guardian Royal Exchange PLC.

Electronic enclosure, thermal management, and industrial tool products firm Applied Power (NYSE: APW) charged up $2 15/16 to $33 7/8 after Goldman Sachs ditched the company's "market outperform" rating, raising it to the vaunted "recommended list"... Specialty and medical bags and packaging products maker Uniflex Inc. (AMEX: UFX) tacked on $1 to $6 3/8 after signing a letter of intent to merge with an entity to be formed by the interestingly named investment firm Carl Marks... Platinum and palladium mining firm Stillwater Mining Co. (AMEX: SWC) gained $2 7/8 to $34 5/8 after Bear Stearns started coverage with an "attractive" rating... Truck manufacturer Navistar International (NYSE: NAV) motored ahead $1 1/2 to $25 1/8 after saying its Q4 and fiscal 1998 earnings will beat analysts' estimates of $1.37 per share and $3.39 per share, respectively, due to strong demand.


A fiscal fourth quarter earnings report that managed to top Wall Street estimates -- thanks largely to reduced costs and a lower tax rate -- wasn't enough to prop up shares of Hewlett-Packard (NYSE: HWP) after the company told analysts to scale back their first quarter and fiscal 1999 projections in a conference call late yesterday. The printer, workstation, PC, and medical and industrial metrology equipment maker gave back $6 1/16 to $60 1/16 today after yesterday reporting Q4 EPS of $0.79 (before special charges of $0.11 per share), compared with $0.75 last year and Street estimates of $0.74. Concerned with stiffening competition and sales weakness in Asia and Latin America, H-P warned that Q1 earnings may fall and fiscal 1999 sales won't meet earlier projections. A First Call survey of 22 analysts currently projects Q1 EPS of $0.87. Unfortunately for shareholders, earnings warnings are hardly uncommon at H-P. In July, the company cautioned that Q3 EPS would fall short of expectations following a similar warning in the preceding quarter.

Investors reacted strongly to threats of Federal action against a big-ticket waste services merger today. Shares of Eastern Environmental Services (Nasdaq: EESI) were trashed $4 1/16, or 14.3%, to $24 3/8 after the Justice Department said it will attempt to block the company's planned $1.3 billion stock-swap merger with Houston-based Waste Management (NYSE: WMI). The department's complaint, to be filed in New York's Eastern District Court, concerns disputes between the companies in markets where both companies have operations. Eastern and Waste Management issued separate statements expressing continued support for the deal, saying they expect a resolution either through discussion or court action. Waste Management remained more or less flat on the day, probably echoing the investor sentiment that yanked the stock down $1 5/16 to $51 3/8 when the deal was announced in mid-August.

QUICK CUTS: Department store retailer J.C. Penney (NYSE: JCP) fell $1 7/16 to $50 3/16 after it said Q3 EPS was $0.68, a penny ahead of Street estimates but missing last year's pre-item $0.85 mark. The company expects a "modest" same-store sales gain in Q4... Home furnishings superstore retailer Bed, Bath & Beyond (Nasdaq: BBBY) lost $9/16 to $25 1/2 after it said co-CEOs Warren Eisenberg and Leonard Feinstein sold a total of 2 million shares of company stock... Managed care company Humana Inc. (NYSE: HUM) hummed down $1 1/8 to $19 3/8 following reports in The Wall Street Journal that the company is in talks to acquire the struggling healthcare division of Prudential Insurance Co. of America for about $1 billion.

Coke bottler Coca-Cola Enterprises (NYSE: CCE) fizzed away $2 to $39 on news of a downgrade to "perform in line" from "outperform significantly" from Schroder & Co... Apparel retailer Men's Wearhouse (Nasdaq: SUIT) frayed $1 3/16 to $24 11/16 after it reported Q3 EPS of $0.21 (before a $0.02 per share charge for retirement of debt), above the $0.17 from a year ago and even with Wall Street's projection. President David Edwab said business activity "continues to meet our expectations"... CMP Group (NYSE: CTP), a holding company for Central Maine Power Co., drained $1 9/16 to $18 1/8 on reports that Florida electricity provider FPL Group (NYSE: FPL) has asked a New York district court to rule that Central Maine Power cannot meet the terms of a January agreement to sell its non-nuclear generating assets to FPL for about $845 million.

Biotechnology company SangStat Medical's (Nasdaq: SANG) stock plummeted $3 1/4 to $24 1/4 following yesterday's news of Q3 losses of $0.64 per share, even with market estimates but well below last year's $0.33 loss. The company reported an additional $0.20 per share charge for the write-off of in-process research and development in connection with an acquisition... Variety store retailer Dayton Hudson (NYSE: DH) lost $2 3/8 to $43 after it reported Q3 EPS of $0.39 (before unusual items), a penny above last year's pre-charge figure and flat with market estimates. Gross margins were 26.8%, a step down from 27.3% a year ago... Teen casual apparel retailer Gadzooks (Nasdaq: GADZ) retreated $1 to $7 15/16 after it said Q3 losses were $0.08 per share, missing both last year's $0.21 profit mark and Wall Street's expected $0.02 loss.

Much-ballyhooed online marketer K-tel International (Nasdaq: KTEL) dropped $5 5/8 to $12 after it said it faces delisting from the Nasdaq because of insufficient tangible net asset value. The company intends to appeal... The recent fall of several hype-driven Internet stocks continued today. Recent IPO theglobe.com Inc. (Nasdaq: TGLO) lost $8 5/16 to $40 7/16 while EarthWeb Inc. (Nasdaq: EWBX) shrank $11 1/4 to $51. Others sporting significant losses included CyberShop (Nasdaq: CYSP), down $9/16 to $10; Globix Corp. (Nasdaq: GBIX), off $1 7/16 to $8 1/4; and AvTel Communications (Nasdaq: AVCO), which dropped $2 5/8 to $7 7/8... EduSoft Ltd. (Nasdaq: EDUSF), which develops and publishes multimedia educational titles, softened $1 3/8 to $6 after it said Q3 EPS was $0.03, well off last year's $0.22. The company is "determined to meet its original 1998 sales goals," according to CEO Menachem Hasfari.

Medical device manufacturer Possis Medical (Nasdaq: POSS) slid $3/4 to $8 3/8 following its announcement of fiscal Q1 losses of $0.26 per share, worse than last year's $0.23 but in line with market projections... Specialty department store retailer Jacobson's Stores (Nasdaq: JCBS) fell $1 5/8 to $7 3/8 after it said Q3 losses were $0.43 per share, compared with a loss of $0.16 per share last year and analysts' consensus estimate for a loss of $0.26 per share. Executives blamed stock market volatility, a warm autumn, and Hurricane Georges for the shortfall... French train and energy generation system builder Alstom's (NYSE: ALS) American depositary shares fell $2 1/8 to $25 7/16 after it said fiscal first-half earnings were 796 million French francs, better than the 686 million francs from last year but short of analysts' expected 920 million franc figure... Cigarette maker Brooke Group (NYSE: BGL), a holding company that owns the Liggett Group, burned off $15/16 to $9 5/8 after it said Q3 net loss was $0.46 per share, compared with a $0.86 loss a year ago.

An Investment Opinion
by Warren Gump

The Government Is Trying To Help!

Watch out, fellow Fools, Armageddon may be near. It appears as if a government agency is attempting to help you. The Securities and Exchange Commission (SEC) is apparently trying to make it a little easier to decipher financial statements. This morning's Wall Street Journal reported that SEC Chairman Arthur Levitt has announced plans to issue new rules that will require more disclosure on items such as restructuring charges, research and development write-offs, loss reserves, and revenues. Alleluia!

Now, I apologize in advance for discussing such a mundane topic, but it really is one that is important to individuals trying to understand the companies in which they are investing. As investors, we look at many different investment parameters. One of the most common, because of its simplicity, is the price-to-earnings (P/E) ratio. You simply take the price of the stock and divide it by the latest 12-month earnings of a company. As a stand-alone number it isn't terribly meaningful, but it becomes more so when you compare it to the P/E ratios of other companies in the industry and the growth rate of earnings over the longer term.

Of course, there are many other factors that investors should look for, depending on the company. You want to make sure a company has a strong balance sheet so that it can fund continued growth and won't be hampered by concerns about how it will pay its debt. It is also worthwhile to look at gross and net margin trends to try to learn more about the competitive dynamics of an industry and the business models of differing competitors. And of course, it is important to look at cash flow, which is the life-supporting oxygen to any business. While these factors (and many others) are worth studying and will likely improve investment analysis, my interaction with many investors indicates that earnings are by far the most prevalent statistics off of which stocks are evaluated.

But really, how valuable are income statements these days? Let's look at Toys "R" Us (NYSE: TOY). Yesterday's Q3 earnings report included a charge of $678 million ($1.93 per share, after taxes). Part of this charge is for "inventory markdowns of $253 million needed to clear excess inventory." This charge, which will be ignored as a one-time nonrecurring event by most investors, will boost the company's income statement over the next eight to ten months as the company clears out this merchandise! How, you ask?

Let's simplify the situation by looking at a fictional small toy company, Stuffed (FOOLdaq: STUFF), which sells only Barney and Teletubbies stuffed animals. The company pays its supplier $7 per animal and charges customers $10. In this year's first quarter, STUFF sells 10 of each animal, giving it revenues of $200 (20*10) and cost of goods sold of $140 (20*7), yielding gross profit of $60. Assuming no other expenses for simplicity, if the company had 20 outstanding shares, it would earn $3 per share. Looking at recent sales trends, however, management realizes that Barney sales are slowing down and those items will need to be put on sale for $5 to sell the 10 left in stock.

From a reporting standpoint, Stuffed can handle this transaction in one of two ways. The most straightforward would be to mark the price down to $5 per doll and account for the dolls as they are sold. Assuming this were to happen, and the company sold 10 of each doll in Q2, the income statement would include revenues of $150 (10*5+10*10) and expenses of $140 (20*7). Excluding other expenses, profit for the quarter would be $10, or $0.50 a share.

Alternatively, management could decide that it needed to take an inventory write-down on the Barney dolls in order to clear them out. To appease the regulators, the company may couch it with other restructuring activity, but we will again just focus on the pertinent transaction for simplicity. In Q1, the company takes a charge of $30 ($3.00 per doll) to write down the value of the stuffed Barneys on hand. When the Q2 income statement is produced, sales remain $150 (10*5+10*10). Expenses, on the other hand, will only be $110 (10*4+10*7). That means profit for the quarter is $40, or $2 per share.

How do our good friends, the Wall Street analysts interpret the above scenarios? In the first situation, the "straightforward" method, the analyst would likely downgrade the stock after the Q2 results were announced because of deteriorating margins at the company. In the second scenario, the analyst would probably come out after the Q1 write-off is announced and cheer management for taking "corrective steps" to its problems, completely ignoring the charge in his valuation models. Then when the Q2 results are reported, the analyst will laud management for being able to maintain its margins. Ummm, excuse me, isn't the underlying financial performance the same? Should the companies really be valued differently because one used more creative accounting?

Going back to the real-life Toys "R" Us example, The Wall Street Journal reported that the company's CFO, Louis Lipschitz, expected that most of the inventory being marked down will be sold over the next eight to ten months. This means, when looking at reported results over that period, you aren't going to really know what the company's gross margin is. What you'll really get is gross margin, favorably adjusted for inventory markdowns. I'd rather have the former. In fact, it would be even more helpful to have results reported using one of the most fundamental accounting principles: matching revenue and expenses.

We can't blame Toys "R" Us or any of the many other companies that are using these accounting techniques. Current accounting and governmental regulations do not prohibit them. In fact, the increasing use of such strategies by some companies is putting pressure on competitors to compare favorably on various financial metrics. By uniformly clamping down on the abuse of write-offs and restructuring charges, the SEC will level the playing field so that companies producing informative and useful income statements will not be disadvantaged. Many people, particularly management teams, will be putting pressure on the SEC to tone down its plans for changes. The folks arguing against these changes believe it is better to serve investors "sugarcoated" earnings statements that show nice, steady growth regardless of underlying economic fundamentals. As investors, we should encourage a tougher stance on restructuring and other "special" charges. Go get 'em, Chairman Levitt!


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